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With their low fees, all-day trading and tax efficiency, exchange-traded funds have captivated investors. There were no ETFs before 1993, and only 80 in 2000. By the end of 2006 there were 359. Today, there are nearly 700, including 280 launched in 2007 and 30 through mid-March this year. They hold about $600 billion.

While most experts think ETFs were a good innovation — built like index-style mutual funds but traded like stocks — some worry that the increasingly specialized ETFs introduced in recent years stray from the faith, encouraging too much risk-taking.

That concern is heightened for some by recent Securities and Exchange Commission proposals to let new funds come to market with less oversight, and to invite proposals for introducing actively managed ETFs. Like actively managed mutual funds, these would employ teams of stock pickers and analysts trying to beat the market’s gains rather than simply match them, as today’s ETFs do. “I can’t imagine anything more absurd than an ETF that is [actively] managed,” says John C. Bogle, retired founder of The Vanguard Group, the leader in index-style mutual funds and ETFs.

Bogle is equally critical of the now-prevalent class of narrowly defined ETFs, which typically focus on stocks of specific industries or countries. “They are great for brokers,” he adds, noting that narrow ETFs appeal to speculators who buy and sell frequently and pay lots of sales commissions. “The question is, are they any good for investors?” Most small investors, Bogle argues, do best by choosing a handful of broad-market index investments and holding them for the long term.

Others experts, however, argue that new types of ETFs can be useful to many investors. “It just gives people more choice,” says Wharton finance professor Franklin Allen, pointing out that narrow focus and active management have long been available in mutual funds. “This is just like mutual funds. It’s just a slightly different organizational form…. If you think health care is going to do well if [Hillary] Clinton gets [elected president], for example, you may want to take a position on that, and these [ETFs] provide an easy, low-cost way to do it.”

Low Operating Costs

The first ETF was the SPDR (Standard & Poor’s Depository Receipt) — commonly known as Spyder — which started trading on the American Stock Exchange in 1993. Still one of the largest ETFs, with $66 billion in assets, it owns the 500 big-company stocks in the Standard & Poor’s 500 index. The value of a Spyder share precisely tracks the index’s ups and downs.

The Spyder follows in the tradition of the first index-style mutual fund offered to ordinary investors — The Vanguard 500 Index introduced by Bogle in the mid-1970s. It, too, tracks the S&P 500, and it is one of the largest funds, with $110 billion in assets.

Because index products simply try to match market returns rather than beat them, they do not require armies of analysts hunting the latest hot stocks. Their operating costs therefore are extremely low. Since they trade like stocks, ETFs require virtually no interaction between the fund company and the investor, producing savings in administrative costs that also minimize fees paid by investors.

While the average actively managed mutual fund charges investors annual fees of about 1.3% of the amount invested, the Vanguard S&P 500 fund charges just 0.18%. Spyders charge just 0.08%. If the market’s annual return averaged 8% a year for 20 years, every $100 invested would grow to $459 in the Spyder, $451 in the Vanguard fund and $366 in the managed fund. The difference: fees’ effect on compounding. While managed funds try to offset this disadvantage with good stock picks, many studies have shown that the average manager cannot do this consistently.

Many investors have had good results with ETFs that track broad market indexes, Allen says. “It’s a good institutional form and it seems to be working very well.”

Mutual fund investors, their investment advisors or brokers buy and sell through a fund’s parent company, such as Vanguard, Fidelity or T. Rowe Price. Orders that come in during the day are filled after the stock market closes at 4 p.m., and investors buy at the share price, or net asset value, figured by dividing the value of the fund’s holdings at the market’s close by the number of fund shares in circulation, or outstanding. As investors’ money flows in, the fund company uses it to buy more shares of the stocks in the fund. When investors withdraw money, the fund sells holdings to free up cash for redemptions, which are paid at the end-of-day price.

ETF shares, in contrast, are created when institutional investors deposit with the fund company a basket of stock shares identical to those in the ETF. In return, the institutional investor receives a “creation unit” — a block of shares in the ETF that are then traded like any other stock. Constant creation and redemption of these units by institutional investors assures that ETF share prices closely track the changing values of the baskets of stocks. Instead of dealing with the fund company, the ordinary investor buys and sells ETF shares through a brokerage, paying a commission as with any stock trade.

Index Funds vs. ETFs

Like all index products, ETFs are especially valuable at tax time.

Mutual funds are required by federal law to make annual payments to shareholders representing the net profits realized on stocks or other assets sold by the fund during the year, and these distributions are taxed in the year they are received. Many managed funds pay big distributions on profits realized as they constantly buy and sell in pursuit of hot investments, thus triggering big annual tax bills.

Index funds, because they hold assets for the long term, do not generate such big distributions. They do, however, realize profits and produce taxable distributions if they have to sell holdings to raise money for customer redemptions. ETFs don’t do this because there are no customer redemptions: Investors who want out simply sell to other investors. Profits from gains in an ETF’s holdings are reflected in the ETF share price and are taxed only after the investor sells the shares.

Because share prices fluctuate throughout the trading day, ETFs are especially appealing to people who want to bet on short-term market moves. Unlike funds, ETFs can be sold short, allowing traders to bet on market declines. Investors also can trade options on many ETFs. They cannot do that with funds.

All-day trading, low fees and tax efficiency have made ETFs a hit with investors, spurring the proliferation of new ETFs. To find new niches and serve investors who want to make very specific bets, newer ETFs tend to be tightly focused. Bogle, who now heads the Bogle Financial Markets Research Center, says only about 15 of the nearly 690 ETFs examined in one of his recent studies track broad-market indexes like the S&P 500. “That leaves 675 doing something very narrow,” he says.

Past history has shown that the more narrowly focused a fund is, the more it appeals to investors likely to jump from one hot part of the market to the next. Since they tend to do this too late and are subsequently disappointed, they habitually buy high and sell low. The average investor’s actual results are therefore considerably worse than the average returns reported by the funds — returns that can only be enjoyed by investors who hold the shares for the entire reporting period.

The gap between investors’ actual returns and funds’ reported returns “gets steeper and steeper and steeper the narrower the portfolio is,” Bogle says. He estimates that only 10% to 20% of the money invested in ETFs is invested for the long term. “It’s very hard to make sense of what is happening in the ETF market.”

Jeff Ptak, head of ETF research for Morningstar, the market-data firm, says most of the funds launched in the past couple of years do indeed have very narrow investment strategies — too narrow to be of much value to ordinary people investing for long-term goals like retirement. “Most of these highly specialized ETFs have no place in your portfolio,” he says. “You have no need for them.” There are, for example, ETFs specializing in stocks of South Africa and Hong Kong, semiconductors, oil-equipment makers or companies that have been spun off from parent firms. Many of the newer funds have failed to attract many investors and are struggling to keep going, Ptak says.

Wharton finance professor Jeremy Siegel, who is senior investment strategy advisor to WisdomTree, a firm that offers fundamentally weighted ETFs — or ETFs based on dividends and earnings rather than market value — says the newer ETF providers are forced to seek narrow niches because turf like the S&P 500 has already been staked out. “The low-hanging fruit has been picked off,” he notes, adding that many small investors are indeed finding the newer ETFs to be too risky. These investors are pulling money out of the newer ETFs, leaving them with insufficient assets to keep going, he says. “Clearly, more of the new ones will fail.”

The SEC’s Tough Hurdle

On March 4, the Securities and Exchange Commission voted to propose a method of streamlining the introduction of new ETFs. If this goes through, as expected, after a two-month comment period, it would make approval almost automatic for new ETFs that employ designs already approved for other ETFs.

The proposal would formalize what has, in fact, been the SEC’s practice for the past couple of years as the agency struggled to keep up with the flood of ETF applications, Siegel says. The first WisdomTree fund, he recalls, was in the registration process for more than a year before being approved in June 2006. “There was a lot of criticism that they were going way too slow.”

The SEC is also seeking comments on whether it should approve actively managed ETFs. Like managed mutual funds, these would use teams of analysts to seek hot investments, rather than simply buying and holding the stocks in a passively managed index. The SEC, however, set a tough hurdle: Managed ETFs will have to immediately disclose changes in their holdings, perhaps daily. Managed mutual funds disclose holdings only every six months, and then state what they own on the reporting deadline without providing details on what they had bought and sold during the previous six months.

Immediate reporting is needed for managed ETFs so that institutional investors could continue to buy and sell creation units, says Wharton finance professor Marshall E. Blume. Otherwise, ETF share prices would not accurately reflect the value of the stocks they represent.

Blume notes there still are many unanswered questions about how managed ETFs would operate and prevent manipulation. “I can see all sorts of shenanigans,” he says. Anyone who knew that an ETF’s holdings were different from those of the creation basket, even if for only a short period, could profitably trade on the knowledge at the expense of the ETF’s shareholders. Since the holdings would have to be disclosed to institutional shareholders very frequently, many people might be in a position to game the system, he says. “So anyone with knowledge of what’s in the fund has to be barred from trading” in ways detrimental to the ETF.

Siegel notes that frequent disclosures can undermine one of the theoretical benefits of actively managed investments by revealing the manager’s strategy and insight into bargains. If everyone knows a superstar ETF manager is buying XYZ stock, others will do the same and the heightened demand will drive the stock’s price up until it’s no longer a bargain. “The advantage of getting in early because you think this is a good buy may be to some extent nullified,” Siegel says.

Vanguard’s Bogle has a harsher criticism of managed ETFs. The whole idea of owning a managed mutual fund, which Vanguard offers alongside its index products, is to benefit from the manager’s skill over the long term, he says. Why, then, would an investor need the ability, offered by ETFs, to trade in and out of the same fund during a single trading day? “I don’t see any added value now that you can trade … all day long in real time.”

Some of the cost benefits found in indexed ETFs will be lost with managed ETFs, since all those stock pickers will have to be paid, Allen says. But managed ETFs may still offer slight cost advantages because they won’t have all the bookkeeping, communication and administrative costs borne by mutual funds. Managed ETFs also should provide some tax savings compared to managed mutual funds, but probably will not be as tax efficient as index ETFs, he says.

Although details are yet to be worked out, managed ETFs probably would have to make annual distributions of net gains on assets sold by fund managers — triggering a tax rarely paid by index-ETF investors. However, like index ETFs, managed ETFs would not have to sell assets to meet customer redemptions.

Despite the many questions about just how managed ETFs will operate, most experts watching the market expect to see them offered in the next year or so.

To preserve the low costs and tax efficiencies of ETFs, a number of the managed variety will operate as a kind of hybrid, using strict rules rather than a lot of stock-by-stock analyses to determine what to buy and sell, Ptak says. Many, he predicts, will build on the “fundamental indexing” model of the WisdomTree funds, which start with standard indexes but then emphasize holding stocks in companies with especially high dividends or earnings. “I think we’re going to see a whole lot of actively managed ETFs,” Ptak predicts. “No question about it.”

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